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Can You Stomach Another 40% Drop?

There's no guarantee we won't fall further.

After seeing the stock market lose half its value and head down toward six-year lows, you may feel like you've suffered more than you'd ever expected with your stock portfolio. Yet as another dour earnings season comes to a close, many see the potential for a much larger drop right around the corner.

The valuation conundrumAs dramatic as the drop in stocks has been since last summer, some market observers who focus on relative valuation wonder how the market has held up even as well as it has. If you focus on recent earnings numbers, the collapse in corporate profits among S&P 500 stocks paints an even bleaker picture of where the stock market ought to be trading.

According to The Wall Street Journal, trailing 12-month earnings for the S&P as a whole are likely to drop below $30, thanks to the recession. At least one pundit has applied an average earnings multiple of 15 to that number and come up with a projected value for the S&P 500 index below 450 -- more than 40% below its close at around 780 on Thursday.

Fair value, or foul?The obvious counterargument to that dire prediction is that the recession has temporarily depressed earnings. After all, earnings for the S&P 500 a year ago were closer to $80, which works out to a P/E below 10 at current levels. If earnings eventually recover to their 2007 levels, then stocks look exceedingly cheap at this point.

But there's no guarantee that earnings will recover anytime soon. Leaving the length of the recession aside, many of the businesses that drove growth over the past several years won't get back to their previous levels of profitability. Even among financial firms that seem likely to survive the crisis, such as Goldman Sachs(NYSE:GS) and JPMorgan Chase(NYSE:JPM), the business model and market conditions that allowed Wall Street to maintain strong profit growth for years no longer exist.

Put another way, even if earnings for the S&P 500 recover fairly strongly -- say 50% from their recession lows -- that still only gets them up to $45. And with the specter of inflation, huge budget deficits, and potentially higher interest rates on the horizon, a P/E ratio of 17 based on that $45 figure sounds fairly pricey.

Protecting against market riskSo with that gloomy prediction, what can you do to cover yourself no matter which way the market moves? One possibility is finding stocks that don't move in lockstep with the market -- and one way to find such stocks is by looking at their betas. Here are some examples of low-beta stocks, which you can see have held up pretty well in the recent bear market:

Stock

Beta (Past 3 Years)

1-Year Return

5-Year Average Return

Altria(NYSE:MO)

0

(25.8%)

9.3%

Aqua America(NYSE:WTR)

(0.05)

(0.5%)

5.6%

Genentech(NYSE:DNA)

0.11

17.1%

12.2%

Strayer Education(NASDAQ:STRA)

0.01

9.2%

12.4%

Fairfax Financial(NYSE:FFH)

0.05

0%

15. 7%

Source: Yahoo! Finance.

The concept of beta is often misunderstood. Many rely on beta as a pure measure of volatility, counting on high-beta stocks to be more volatile than stocks with low beta values. But that's only true to the extent that a stock's returns are correlated with the overall market. A stock that moves independently, however, might well show a low beta, but its overall price movements might be fairly volatile.

So while low-beta stocks may provide some protection against a crash, they're no guarantee of positive performance. And of course, if the market rebounds, you'd do better in high-beta stocks that take greater advantage of bull markets.

Be readyNo matter what you do to protect your money, you need to be prepared mentally for what you'll do if stocks crash again. As unfair as it might seem to have to consider further losses after what you've already been through, counting on this being the worst of it is just too dangerous. As cheap as many stocks are right now, they could get cheaper -- and if you're on the edge of panicking already, you need to steel yourself for whatever comes next.

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Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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